By Wolf Richter: What Happens When the Machines Start Selling?

In the good old days not so long ago the price of a stock was determined by a company’s profit, growth potential, and balance sheet. With of course some irrational exuberance thrown in from time to time.

Today reality is irrelevant. Everything is now irrationally exuberant on steroids.

The infamous FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google’s parent Alphabet – along with other “tech” stocks have been getting “hammered,” to use a term that for now exaggerates their “plight.” The FAANG stocks are down between 1.7% and 2.5% at the moment and between 5.5% and 11% since their peak on June 8. Given how far these stocks have soared over the past few years, this selloff is just a barely visible dip.

But fundamental analysis has long been helpless in explaining the surge in stocks. The shares of Amazon now sport a Price-Earnings ratio of 180, when classic fundamental analyses might lose interest at a PE ratio of 18 for the profit-challenged growth company that has been around for over two decades. For them, the stock price might have to come down 90% before it makes sense.

Or Netflix, with a PE ratio of 195. Or companies like Tesla. Forget a PE ratio. There are no earnings. The company might never make any money. Its sales are so minuscule in the overall US automotive market that they get lost as a rounding error. It bought Elon Musk’s failing solar-panel company as a way to bail it out. And the battery-cell technology Tesla uses comes from Panasonic. So what should a company like this be worth? Fundamental analysis has been completely irrelevant: Tesla’s current stock price gives it a market capitalization of $61 billion.

So investors trying to sort through this mess by using fundamental analysis have been left in the dust years ago. Fundamentals no longer matter in this market. Valuations have been surgically removed from any sense of fundamental reality.

There are a lot of reasons for this, including the enormous amounts of liquidity in the markets, after the Fed, the ECB, the Bank of Japan, the Bank of England, and the Swiss National Bank have created $11 trillion out of nothing since the onset of the Financial Crisis and used that money to buy $11 trillion of securities – in the SNB’s and BOJ’s case even common stocks. They now sit on $15 trillion in assets.

Under such relentless buying pressure, fundamentals in the markets have become useless. People still truly engaged in it – rather than in churning out “fundamental” rationalizations for irrational stock prices – are being ridiculed. But algorithms have picked up the slack.

“The majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,” Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, explained in a note to clients, cited by CNBC.

“Fundamental discretionary traders” now account for only about 10% of trading volume in stocks, he said. Passive and quantitative investing account for about 60%; this share has more than doubled over the past decade.

These “big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come,” he said.

Since fundamental analysis of specific stocks and companies no longer influences trading decisions, the sell-off in tech stocks can’t be the doing of those still hopelessly clinging to fundamental analysis. Instead, it was likely associated with some change in strategy by quantitative and algorithmic trading. The algorithms were reacting to something.

But these algorithms – many of them written by people who went to the same schools and learned the same things – and the vast amounts of data they churn through end up doing similar things, following similar strategies, and producing similar results. Hence, the surge of FAANG stocks and other stocks to where fundamentals are just a quaint reminder of a bygone era.

But without fundamentals, what will hold up stock prices, once the quantitative strategies shift without notice and see selling as the opportunity, and other algos react to those market data points and follow them or try to run ahead of them? No one knows.

This environment has amassed phenomenal risks. These shifts, as we have seen with the tech stocks, can occur without prior notice, without obvious trigger. They occur because an algo sets it off and other algos follow since they react to each other, and the whole machinery can suddenly go into reverse and get stuck in it.

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Favorite Quotes

For explaining why humans are odd
To Varki and Brower we applaud
A great mystery they solved
With denial we evolved
And created the Higgs, overshoot, and God

Denial not only makes us believe in god, it is god, because denial created us, and denial may destroy us.

The human brain, the God it believes in, and the overshoot it enabled and denies, all resulted from the same improbable genetic adaptation that occurred about 100,000 years ago.

Denial is the reality that must be most aggressively denied to avoid collapsing the house of cards that keeps us functioning.

The most amazing thing about human overshoot is that we do not discuss it.

You know you are in trouble when reduced CO2 emissions from an economic collapse caused by low-cost oil depletion is not sufficient to prevent civilization collapse from climate change caused by previously emitted CO2.

Our only choices are do we want to fall from a higher elevation later, or climb down from a lower elevation sooner?

Things that can’t continue usually stop too late.

Truth is like poetry and most people hate poetry.

All 8 billion of us owe our existence to a six-inch layer of topsoil and the fact it rains; 6 billion of us also owe our existence to nitrogen fertilizer created from natural gas by Haber-Bosch factories.

While it digs its own grave, all the mind can do is entertain fantasies and create excuses.

When the only paying job in town is sawing off the branch which you are sitting on, you….saw away! You might refuse to saw and hang yourself from that branch, but the end is the same anyway, and that option is much less fun. (Cynic @Megacancer)

It is remarkable that a brain emerged from a cloud of hydrogen and figured out the laws of physics that governed, and possibly made inevitable, its own creation and destruction.

We have met the oblivious and they are us.

All 8 billion of us originated from one small tribe in Africa about 100,000 years ago that gave birth to a child with an improbable mutation for a more powerful brain that denied reality. The other tribes were soon toast and we took over the planet. We’re all close cousins. I love you all. Except the deniers.

Meaning comes from understanding why we can understand there is no meaning.

Way too many smart people with big reputations are wrong about everything that matters. Something’s gonna happen that gives them an excuse not to have to admit they were in denial.

One of the most, if not the most, precious and rare things in the universe is the human brain. We have a cosmic obligation to use it and to confirm it works.

Fire to cooking to intelligence to denial to god to plotting to capital punishment to self-domestication to Apollo 11 to 7 billion too many.